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Dark Clouds or Silver Linings? Knightian Uncertainty and Climate Change

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  • Yu-Fu Chen
  • Michael Funke
  • Nicole Glanemann

Abstract

This paper examines the impact of Knightian uncertainty upon optimal climate policy through the prism of a continuous-time real option modelling framework. We analytically determine optimal intertemporal climate policies under ambiguity. Additionally, numerical simulations are provided to illustrate the properties of the model. The results indicate that increasing Knightian uncertainty accelerates climate policy, i.e. policymakers become more reluctant to postpone the timing of climate policies into the future.

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File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2011/wp-cesifo-2011-07/cesifo1_wp3516.pdf
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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3516.

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Date of creation: 2011
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Handle: RePEc:ces:ceswps:_3516

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Keywords: climate change; Knightian uncertainty; ê ambiguity; real options;

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References

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  1. Weitzman, Martin L., 2009. "Additive damages, fat-tailed climate dynamics, and uncertain discounting," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, Kiel Institute for the World Economy, vol. 3(39), pages 1-29.
  2. Antony Millner & Simon Dietz & Geoffrey Heal, 2010. "Ambiguity and climate policy," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 37595, London School of Economics and Political Science, LSE Library.
  3. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(1-2), pages 145-166.
  4. Brennan, Michael J. & Schwartz, Eduardo S., 1978. "Finite Difference Methods and Jump Processes Arising in the Pricing of Contingent Claims: A Synthesis," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 13(03), pages 461-474, September.
  5. Michael Funke & Michael Paetz, 2011. "Environmental policy under model uncertainty: a robust optimal control approach," Climatic Change, Springer, Springer, vol. 107(3), pages 225-239, August.
  6. Giuseppe Bertola, 2010. "Options, Inaction, And Uncertainty," Scottish Journal of Political Economy, Scottish Economic Society, Scottish Economic Society, vol. 57(s1), pages 254-271, 07.
  7. Leahy, John V, 1993. "Investment in Competitive Equilibrium: The Optimality of Myopic Behavior," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 108(4), pages 1105-33, November.
  8. Takao Asano, 2010. "Precautionary Principle and the Optimal Timing of Environmental Policy Under Ambiguity," Environmental & Resource Economics, European Association of Environmental and Resource Economists, European Association of Environmental and Resource Economists, vol. 47(2), pages 173-196, October.
  9. Pindyck, Robert S., 2012. "Uncertain outcomes and climate change policy," Journal of Environmental Economics and Management, Elsevier, vol. 63(3), pages 289-303.
  10. Martin L. Weitzman, 2009. "On Modeling and Interpreting the Economics of Catastrophic Climate Change," The Review of Economics and Statistics, MIT Press, vol. 91(1), pages 1-19, February.
  11. Vardas, Giannis & XEPAPADEAS, Anastasios, 2008. "Model Uncertainty, Ambiguity and the Precautionary Principle: Implications for Biodiversity Management," MPRA Paper 10236, University Library of Munich, Germany.
  12. Zengjing Chen & Larry G. Epstein, 2000. "Ambiguity, risk and asset returns in continuous time," RCER Working Papers, University of Rochester - Center for Economic Research (RCER) 474, University of Rochester - Center for Economic Research (RCER).
  13. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  14. Ottmar Edenhofer , Brigitte Knopf, Terry Barker, Lavinia Baumstark, Elie Bellevrat, Bertrand Chateau, Patrick Criqui, Morna Isaac, Alban Kitous, Socrates Kypreos, Marian Leimbach, Kai Lessmann, Bertra, 2010. "The Economics of Low Stabilization: Model Comparison of Mitigation Strategies and Costs," The Energy Journal, International Association for Energy Economics, International Association for Energy Economics, vol. 0(Special I).
  15. Richard Tol, 2002. "Estimates of the Damage Costs of Climate Change. Part 1: Benchmark Estimates," Environmental & Resource Economics, European Association of Environmental and Resource Economists, European Association of Environmental and Resource Economists, vol. 21(1), pages 47-73, January.
  16. Nishimura, Kiyohiko G. & Ozaki, Hiroyuki, 2007. "Irreversible investment and Knightian uncertainty," Journal of Economic Theory, Elsevier, Elsevier, vol. 136(1), pages 668-694, September.
  17. Weitzman, Martin L., 2009. "Additive Damages, Fat-Tailed Climate Dynamics, and Uncertain Discounting," Scholarly Articles 9639963, Harvard University Department of Economics.
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Cited by:
  1. Chen, Yu-Fu & Funke, Michael & Glanemann, Nicole, 2012. "Time is Running Out: The 2°C Target and Optimal Climate Policies," SIRE Discussion Papers, Scottish Institute for Research in Economics (SIRE) 2012-17, Scottish Institute for Research in Economics (SIRE).
  2. Michael Funke & Yu-Fu Chen & Nicole Glanemann, 2011. "Time is Running Out: The 2°C Target and Optimal Climate Policies," Quantitative Macroeconomics Working Papers, Hamburg University, Department of Economics 21111, Hamburg University, Department of Economics.

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